You want to sell your current home and use the sales proceeds to make a down payment on a new home. But what if your home doesn’t sell as quickly as you expect it to, and you’re forced to miss out on opportunities to bid on homes as they hit the market?
This is a common dilemma for homeowners. Fortunately, bridge loans, home equity loans and HELOCs can make securing a second home easier. There’s also another option to get the funds you need for a down payment on a second property, and it doesn’t require you to take on more debt.
What is a Bridge Loan and How Does It Work?
A bridge loan is a short-term debt product commonly used by homeowners in the market for a new home. If you’re looking to buy a new home before selling your current home, you can use the loan proceeds to cover the down payment.
These types of loans are secured by your existing home or other assets, and most lenders offer repayment terms between six months and one year.
Unfortunately, bridge loans could be problematic if it takes a while for your home to sell. More on that shortly.
Bridge Loan: Example Scenario
A homeowner finds a new property they want to move into that costs $1 million. The homeowner doesn’t have enough funds for a down payment but wants to sell their current home. The timing of selling your current home and buying your new home can get complicated, but a bridge loan can help.
A borrower in this scenario can take out a $200,000 bridge loan to cover the down payment. Then, once the dream house is purchased and the old home is sold, the homeowner can use those proceeds to pay off the bridge loan.
What is a HELOC and How Does It Work?
A home equity line of credit (HELOC) is another way to secure the down payment needed for a second home purchase. Most lenders allow you to borrow up to 80 percent of your home’s equity minus what you owe on your mortgage.
So, if your home is worth $395,000 and you owe $285,000, you could get a HELOC for up to $31,000 ($395,000 * .80 – $285,000).
Upon approval, you’re given access to a pool of cash that you can withdraw from and repay during a set amount of time, referred to as the draw period. You will also make interest-only payments on the amount you borrow while the HELOC is active.
Once the draw period ends, the outstanding balance is converted into a loan payable in monthly installments over an extended period. The payment amount could fluctuate as the interest rate is usually variable on HELOCs.
HELOC: Example Scenario
A real estate investor may use a HELOC to cover the down payment for a rental property. It acts as a second mortgage and allows investors to scale their portfolios.
Assume an investor is looking at a property worth $500,000. This investor already has a primary residence with $300,000 in available equity. Instead of borrowing all $300,000, the investor may only borrow enough money to make a 20% down payment. In this example, the investor takes out a $100,000 HELOC to cover the purchase of a new home.
If the investor sells the property with the HELOC, the loan’s proceeds would cover the HELOC. However, investors can opt to build equity in multiple properties simultaneously so they can fund additional down payments.
What are the Similarities Between a Bridge Loan vs. a HELOC?
Either loan can be a good option for your finances. These are some of the commonalities between these short-term financing options.
- Both require you to have equity in your home: Most lenders want you to have at least 20 percent equity in your home to qualify for a bridge loan or HELOC.
- Both are secured loan products: Your home is used as collateral to secure the loan and could be foreclosed if you fall behind on payments.
- Less stringent qualification criteria: The lending requirements for bridge loans and HELOCs are sometimes laxer than what you’ll find with other home loan products.
Bridge Loan vs. HELOC: How They Differ
Knowing the differences between these short-term loans can have a significant impact on your long-term wealth. These are some of the key differences.
Purpose
Bridge loans cover the gap between receiving financing and making a purchase. You may want a conventional mortgage or a jumbo loan, but you don’t have to wait as long if you use a swing loan instead.
HELOCs offer a similar dynamic but also come with more flexibility. You can use a HELOC for everyday expenses or to act as a bridge while waiting for a loan to get approved. However, you must have enough equity in your property to take out a sufficient HELOC.
Loan Use
Bridge loans are strictly for filling in the gap while waiting to get approved for a loan or for a property sale. HELOCs can be used for additional purposes.
Loan Structure and Term
Bridge loans have shorter terms, while HELOCs have draw periods that can last up to 10 years. HELOCs offer more flexibility that can do a better job of aligning with your financial situation.
Fund Disbursement
Bridge loans and HELOCs both make your cash accessible. However, bridge loans give you a lump sum that you can use right away. Interest starts to accrue on your balance immediately. However, you only pay interest on a HELOC when you borrow against the credit line. You can take out a lump sum with a HELOC, but you also have the option to keep your equity on the sidelines until you are ready to make a purchase.
Interest Rates
You will likely get lower interest rates if you use a HELOC. Bridge loans tend to have high interest rates compared to other financial products.
Eligibility Criteria
It’s easier to get a HELOC than it is to get a bridge loan.
Homeowners with at least 20 percent of equity in their homes generally qualify for HELOCs. You should also have a steady source of income, a good or excellent credit score and a debt-to-income (DTI) ratio that’s not too excessive and meets the lender’s requirements.
You could qualify for a bridge loan if you have at least 20 percent equity in your current house. It’s also best if you meet the qualification criteria for a mortgage before applying.
It’s possible to get a HELOC if you have a combined 90% LTV ratio. However, most bridge loan providers limit the LTV ratio to 65% to 80%.
How to Get a Bridge Loan
You can reach out to a financial institution, credit union, or an online lender that offers bridge loans. Consumers can apply for these loans by providing basic information like their ID, Social Security Number, and proof of income.
How to Get a HELOC
The process is similar to a HELOC. You should compare lenders and shop around before deciding which offer makes the most sense for you. Once you find the right rate and terms, you will then have to submit your application. A good credit score and a low DTI ratio will increase your chances of getting approved.
Choosing Between a Bridge Loan vs HELOC
It’s a big decision to choose between a bridge loan and a HELOC. These are some of the factors to consider.
Factors to Consider When Deciding Between a Bridge Loan and a HELOC
Total Costs
Most bridge loans are accompanied by steep interest rates. It varies by lender, but many charge between 3 and 11 percent. You will also pay closing costs between 1 and 3 percent of the total loan amount. These types of expenses include loan origination, administrative fees and appraisal fees, escrow fees, notary fees and title policy costs.
Like bridge loans, you will also incur fees and closing costs if you get a HELOC. Also, be on the lookout for maintenance fees, which are sometimes assessed annually, along with minimum withdrawal and inactivity fees. You could also be charged a cancellation fee if you close your HELOC early.
Timeframe
HELOCs are more accommodating if you need extra time to bridge the gap. Bridge loans have shorter terms, which can result in a necessary refinance if the deal stalls. Bridge loans get more expensive over time and do not leave much room for error.
Interest Accumulation
You only pay interest on a HELOC if you borrow against the credit line. While you can take your time with borrowing funds from a HELOC, you will immediately accrue interest with a bridge loan.
Credit Score
You typically need a 700 FICO score or higher to qualify for a bridge loan. HELOCs have lower requirements. It’s possible to get a HELOC with a score as low as 620. Regardless of which option you choose, it’s a good idea to work on your credit score leading up to the application. You will get better rates and terms if you add a few extra points to your score with on-time payments and by paying down debt.
When to Use a Bridge Loan
Suppose your current home is already under contract but won’t close before you purchase your new home. In that case, a bridge loan could be a sensible option if you need the funds from your current home to make a down payment on your next home.
But if you anticipate it taking some time to sell your current home, a bridge loan may not be worth it. You risk paying a fortune in interest or digging yourself into a financial hole by having to pay off a sizable loan in a short period.
Pros:
- Get short-term financing while waiting for a real estate deal to go through
- You won’t have to rent
- Make a down payment that doesn’t involve any profits from the future sale of your current home
- You can make interest-only payments at the beginning of your term
Cons:
- Higher interest rates than most mortgages
- These loans have short terms, which can require refinances to avoid significant monthly payments
- Variable prime rates increase over time and are common among bridge loans
- It’s possible that a deal does not go through, resulting in significant expenses and debt
When to Use a HELOC
If you use a HELOC to make the down payment on your second home, you’ll likely save a bundle in interest. Furthermore, your monthly payments could be much lower, assuming you sell your first home before the draw period ends.
HELOCs are also useful for homeowners who want additional flexibility. You can continue to draw funds from the HELOC if you pay it off the first time. Some homeowners may prefer to use their HELOC for a property’s down payment and scale their real estate portfolios. Not everyone wants to switch primary residences. Some people prefer to own both pieces of real estate.
Pros:
- You only pay interest when you borrow against the credit line
- Lower monthly payments during the draw period
- You can borrow against a HELOC again after you have replenished it
Cons:
- Variable interest rate creates less predictability with how much interest will accumulate
- Closing costs and other fees
- Your property is used as collateral
Conclusion: Choosing Which One is Right for You
Bridge loans and HELOCs both have a lot to offer if you need extra short-term financing. While bridge loans can help out when you are in a pinch and start off with interest-only payments, these loans are more expensive. Bridge loans can also become burdensome if you cannot secure a deal.
Home equity lines of credit are the better choice for most people. These financial products are more affordable and flexible. HELOCs come with draw periods that are as long as 10 years, and you only pay interest when you borrow money against the credit limit. Once you repay a HELOC, you can use it again for another expense if necessary.
Consumers should assess their personal finances before making a decision.
